Value Based Management: A Strategic Panacea for High Productivity
The idea that it is the responsibility of the corporate management to enhance the shareholder's value has been embraced to a great extent. With competition intensified, massive privatization initiatives and global markets being more interconnected than ever the main agenda had shifted to value creation through value based management .Many of the leading companies have accorded value creation as a central theme seen as a strategic panacea in their corporate planning with the objective of high productivity .Now top management compensation is linked with shareholder returns through optimized and efficient value based management.
It is imperative to determine whether management has created or destroyed value including the market value of the firm's capital which has both debt and equity component .A comparison may be made between capital invested by the shareholders and lenders (which is equivalent to capital employed in the firm). The final difference between the market value of the capital and capital employed is called market value added.
The value based management works on some of the key premise .The first is the current value of any company or its investments or the strategies is equal to the present value of the future cash flow the company is expected to produce .The second premise is that the conventional accounting earnings are necessarily not the sufficient indicators of value creation because they are not the same cash flows as they don't reflect the risk not they indicate any type of opportunity cost .They also don't consider the time value of money .The third premise is that there is a need for a well designed performance measurement and incentives compensation system to motivate employees to focus their attention in creating the shareholder's value.
One of the key determinants of the value drivers is the capital employed. This financial metric is derived from the balance sheet. The equity and the debt component are important elements. To get the handle over the amount of the equity employed one needs to add to the specified book of equity reported in the balance sheet .Several of the items such as deferred tax provision, allowance of the bad debts, research and development expense and amortization in a good will are included. The level of the debt capital includes all the different forms of the borrowings and the other obligations like the level financial leases which are equal to the debt obligation.
Drivers of Value Creation: The important components of the value drivers are weighted average cost of the capital, profitability measured by its after tax return on the invested capital which is equivalent to the return on the capital employed and finally the growth rate of the firm .In accordance to these components the value is created when the expected return spread (ROIC-WACC) is positive .The value of the firm is destroyed when (ROIC-WACC) is negative. It is also interesting to interpret that value is neither created nor destroyed when (ROIC -WACC) is zero. The entire gamut of the future stream of the expected return spread drives the value creation. It is necessarily not always true that growth per se creates value. The growth may be value creating when the expected return spread (ROIC>WACC) is positive. Growth is value neutral when the expected return spread is zero (ROIC=WACC).
The firm's expected ROIC into its fundamental components can be represented mentioned below..
ROIC = (PBIT/SALES)* (Sales/Invested Capital) * ( 1-Tax Rate ) .
As per the above mentioned formula the ROIC of the firm can be optimized by three measures .First the operating profit margin worked towards upward trend(PBIT/Sales).Second the Capital turnover ( Sales/Invested Capital) is increased. Third the effective tax rate is reduced.
If we look into broader prospect the organization in the modern era needs to adhere to non financial goals too. The focal point should be issues pertaining to customer satisfaction, employee satisfaction, product innovation and ability to build leadership pipeline with a long term view .Inherent qualities like ability to guide and inspire the entire organization can also be crucibles for driving change. Such objectives don't contradict with the value maximization. The most successful companies globally like GE , Apple and Microsoft excel in non financial goals which gives further impetus to the financial performance of the organization .Under certain exceptional circumstances the non financial goals should be well tailored when the need of the hour demands survival and turnaround strategy .For example a defense sector in USA where the growth contraction is a certainty the organization has to look into the human capital requirement and can't adopt a no layoff objective.
The objectives should be well integrated at different levels of the organization. A functional manager's goals may be different from head of a business unit head .The former's goal may be expressed in terms of customer service , superior product quality ,productivity and market share .The later's objective may be focused towards value creation measured purely in financial terms. Similarly the manufacturing manager may just focus on cost per unit, defect rate or cycle time. In the areas of the product development issues might be relating to time lines to develop a new product, the number of the new products developed and competitive analysis of the predermined performance indicators in the market.
At the senior management level the major focus in on corporate strategy which can potentially optimize the overall value of the company .This may include buying or selling of the business units or getting in strategic alliance as a part of the growth strategy with the mission of the company in mind .At the business unit level there is also a need for identifying the alternative strategies with appropriate value measuring mechanism and choosing the ones with best potential to create the maximum value. Once the strategy has been chosen it should be clearly addressed how it can achieve a competitive advantage for the business unit and in the process create value.
The strategy should be more pertinent having important illustration and analysis of the competitors , the existing and potential markets ,the unit's assets and skills .After the thorough analysis has been done the key elements of the value based management may be figured as assumptions and results of the valuation driving the value of the strategy laid out . The assumptions are to be carefully arrived in consultation with the senior management which should be constantly challenged through debates and discussion to arrive at the most accurate one for the best projected values which can become a reality. The resources with assets specification involving business unit requirement and human capital should be well articulated .There should also be space, scope and flexibilities for alternative strategies. The strategic plan projections should be well summarized focusing on the key value drivers .These should be supplemented by the analysis of the return on the invested capital over time and relative to the competitors. Business unit strategies have not become sort of time sink but actually the costs associated with the planning can drastically be reduced if value based management is introduced simultaneously with the integration of the planning process at all levels in the value chain. This can further be made more credible through scenario planning to assess and weigh the potential competitive threats and opportunities.
One of the renowned US based chemical company designed extremely effective way to review performance .In year's time it was expected that the data reported would be more transparent. Contrary to expectations there was hardly any improvement .There was introspection in this regard. It revealed that official discussion about the performance were somewhat of a sham. There were flaws the in the Manager's reports which were desultory with huge deviation in projected values and actual performance over specific period of time. They made wrong assumptions.
The CEO was quick to act .He directed to change the review process. What was initially just one to one discussion became broader discussion involving number of other people including division head and all unit leaders together. Rather than just reviewing the data the meeting focused more on the lessons from the previous reporting period .What were the opportunities and threats that were expected to come in the reporting period .There was a pragmatic shift of focus from individual success and failures to a combination of shared lessons and problem solving .The company next introduced series of well coordinated peer meetings among the unit leaders without division heads .This was primarily aimed to review plans and identify key risks with opportunities to set the priorities right while allocating capital and the resources. With the new processes in place change became more transparent and seen in the form of reduced capital outflows which dropped more than 25 per cent .The profits rose by 10 per cent with adjusted usual modulation of the business cycle.
To recapitulate the benefits of value based management are myriad. They are in the form of satisfied customers, correctly assigned resources, and streamlined process that deliver, growing profits, motivated and more accountable people. There is elimination of wastes, assimilation of facts that makes the business better managed and hence optimizing the company's overall performance.
